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Those of us who enjoy the luxury of observing the markets by lofting a dampened finger in the air, rather than thrusting a spade in the ground to make money actually grow, can enjoy a remarkable set of investor debates right now, many of which come down to yes-yes questions.
Q: Is the heady upward run in the major stock indexes, which has resulted in them doubling or better in three years, a product of the Federal Reserve's extraordinary largesse or of corporate profit growth? A: Yes.
There's no denying that the Fed's policy of anchoring short-term interest rates near zero and flushing conjured capital into the financial markets has fed risk appetites and pushed up the value of assets, both paper and real. Indeed, the Bernanke Fed's main distinguishing feature isn't that he seeks validation from a strong stock market, but that he admits it.
The doubling of the stock market has almost precisely tracked the path of large-company earnings. In 2009's first quarter, when the Standard & Poor's 500 bottomed below 700, earnings of S&P companies were $12.83 per share. In the current quarter, the consensus forecast is $24.69. It's hard to get closer to an exact doubling of Corporate America's bottom line.
A related debate involves whether corporate profit margins are so uncommonly high that they won't last, or whether they are sustainable. Once again, the answer seems to be yes.
Margins have been running above 9% for S&P 500 companies, and have rarely been higher in history. This has raised alarm in some quarters that this bounty will be surrendered, in the necessary manner of capitalist competition. It will, of course, but perhaps not for a while.
We are in an age of a New Corporateocracy, with large companies the only flush players in a world of overindebted developed-market governments and chastened First World consumers. Deutsche Bank strategist Binky Chadha argues that, as analysts continue to play catch-up to earnings momentum, margins are well supported by emerging pricing power, lagging labor costs and operating leverage to quickening top-line growth.
OK, so profits have been great, and possibly can keep exceeding forecasts. But, given that, is the market cheap or expensive? You bet!
Based on the excessively popular, and borderline punitive, market valuation method espoused by Yale's Robert Shiller, a price/earnings ratio that uses the past 10 years' average annual earnings as the denominator, the market is quite pricey. This is meant to capture the "normalized" earnings rate. But it's fair to question any measure that uses the gargantuan 2008 losses of AIG, General Motors and other then-hobbled companies to compute a "normal" run rate. Less debatable is the fact that small-cap shares and the median stock in the market are pretty richly priced.
As S&P 500 earnings motor toward a $100 annual pace, however, the senior indexes hardly carry demanding valuations. Tony Dwyer, strategist at Collins Stewart, last week took the role of pacesetter for bullish handicappers. He placed a 1575 target for 2011 on the S&P 500, now around 1350, based on a $105 earnings estimate and a 15 times multiple, which history argues is doable, given current core inflation rates.
It would seem that cheapness isn't the reason to buy stocks at this stage of a bull market, yet stocks aren't so blatantly expensive that valuation argues for bailing out. The economic data will need to re-establish momentum for the market, but re-leveraging and merger-and-acquisition activity will remain supportive.
When there are so many yes-yes questions, it's easy to feel the arguments cancel one another out. And indeed these debates suggest the market could be vulnerable to some backsliding. Yet with the trend resolutely positive and little internal evidence of a market top, it still seems the burden of proof resides with the market skeptics.
EVEN ON JUST ITS OWN MERITS, Expedia (ticker: EXPE) looks cheap. Its free cash flow should hit $2.78 a share this year and rise a bit in 2012, says RBC Capital's Ross Sandler. That's more than 11% of the $25.17 or so that investors now are paying for the shares, and indicates the price should be closer to $30. Yet the pending spinoff of the TripAdvisor travel-advice Website -- billed by some as the first publicly traded social networking venue -- should highlight Expedia's full embedded value. Fears are rampant that Google Places, a travel-search service, will drain traffic from TripAdvisor. Yet Google's (GOOG) ambitions frequently exceed its triumphs. Based strictly on cash flow and company valuations, some hedge-fund investors peg Expedia's value at $34 to $42.
E-mail: michael.santoli@barrons.com
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